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March 10, 2014

‘The Biggest Threat We Face Might Be Economic Growth’: Merk

Axel Merk warns that economic growth leading to rising interest rates would have the unwanted effect of adding $1 trillion in interest expense to finance our deficit

In a recent commentary, the chief investment officer of Merk Investments, which managers four currency-based funds, offers a variety of unflattering comparisons between U.S. monetary and fiscal management and that of the oft-maligned eurozone.

The euro, he notes, bested the dollar two years ago in the midst of the eurozone crisis, and last year as well.

U.S. monetary policy, with its emphasis on the purchase of Treasury and mortgage-backed securities, has kept rates low.

But rising rates — to be expected as the Federal Reserve tapers its bond purchases — have been associated with a weakening dollar, Merk says.

A greater problem, however, is our inability to afford positive real interest rates.

And if rates returned to their historic average of 5.6% between 1973 and 2012, the ensuing $1.2 trillion in interest expense (from our current $220 billion) would overwhelm the federal budget.

The currency investor sharply criticized what he sees as the Yellen Fed’s abandonment of its price stability mandate, arguing the Fed actually wants inflation “to push up home prices … and to dilute the value of government debt.” Such a policy is a further blow to the long-term value of the dollar.

In contrast, the “ugly duckling” euro, as he calls it, has not taken the Fed’s money printing approach.

Whereas the U.S. has expanded its balance sheet by close to 360% since August 2008, the European Central Bank's balance sheet has expanded about 50% over the same time period.

Moreover, “the cost of borrowing for weaker eurozone countries has been falling since August 2012,” he writes; the contraction in the spread between Spanish 10-year bond yields over the German benchmark from well over 6% to about 2% today adds an important source of stimulus, he says.

Merk describes a number of efforts and ideas to weaken the value of the euro — which for structural and other reasons have been ineffective — which is further good news for euro currency investors.

The eurozone has been “healing,” he says, noting that European flare-ups no longer trigger “contagion,” as in previous crises involving Cyprus and Spain. A sign of the improvement is the healthy development of hedge funds buying Greek banks and Spanish real estate — risk investments that, if they go wrong, will damage wealthy private investors rather than major European banks as in the past.

The U.S., on the other hand, is saddled with a massive current account deficit, which, as he puts it, means it “needs to attract over 1 billion U.S. dollars every day to keep the currency from falling,” in contrast to internally financed eurozone budget deficits.

That makes the U.S. vulnerable to bond vigilantes in the future, Merk warns.

“If [the] bond market acts up the U.S. dollar might come under more pressure than the euro has ever seen," he concludes, "and would force policy makers to impose reforms.”